Pete Wargent blogspot

Co-founder & CEO of AllenWargent property advisory & buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place) - clients include hedge funds, resi funds, & private investors.

4 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the better property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete Wargent is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"Pete's daily analysis is unputdownable" - Dr. Chris Caton, Chief Economist, BT Financial.

Invest in Sydney/Brisbane property markets, or for media/public speaking requests, email pete@allenwargent.com

Monday, 13 August 2012

Reversion to the mean

Mean reversion
‘Reversion to the mean’ – you may have heard the phrase, but what does it refer to?
Mean reversion is a mathematical concept which notes that while the prevailing price of an asset is sometimes overvalued and sometimes undervalued, over time it will tend to revert towards a long-term average.

The idea is often used by traders in the stock markets so that when a share price is considered to be below its long-term average or intrinsic value then it is deemed to be a ‘buy’ and if it is above its long-term average it is marked as a ‘sell’.
If we buy when prices are attractive then theory says that eventually the price is likely to revert to the average valuation and we will profit.
The concept can easily be applied to other asset classes to include including exchange rates, commodities or real estate.
The flaw in mean reversion for stock prices
There is one fatal flaw in the mean reversion concept for the behaviour of share prices. If you stop to think about it, you might be able to work out what it is.
The flaw is that the mathematics takes no account of the legal status of a company which is able to file for bankruptcy. In other words, if a company becomes insolvent, a stock price can hit zero and stay there forever: it will never return to an average price.
While property prices can rise and then fall sharply as we have seen in the United States, they will never hit zero as the land will always retain value, particularly if it is land which is in continual high demand.
Long-term trends
If we look at the long-term trend of market prices we can begin to make some useful observations.
Firstly, we can note that the trend for both stocks and property is an upwards one. Secondly, that while at times prices become speculatively high or demoralisingly low, prices do tend to revert to an average over time.

We can also see that while market crashes seem devastating when they are occurring (2008-2009 still currently looks extremely painful in the rear-view mirror), experienced investors wisely consider that ‘this too shall pass’.
Observe the bursting of the technology stock bubble in 2002, which now appears to be of less consequence. The sheer terror of the 1987 Black Monday crash unravelling now begins to resemble a minor blip in the chart.
Seasoned investors sometimes delete sections of price charts and ask those who are less experienced to consider what would happen to their investing psyche if they were able to ‘switch off' the market noise for long periods (something which property investors are usually better able to do than share investors due to the historic lack of a daily quoted market price).
History shows us that while prices can crash sharply, the crashes often follow a period of irrational exuberance. The ‘huge’ stock market crashes of 1929 (Dow Jones falling from 380 to 200) and 1987 (the Dow again falling by approximately 500 points to around 1,750), for example, were both immediately preceded by irrational appreciation in market valuations.

Despite crashes continuing to occur cyclically, today the Dow Jones sits far higher at around 13,200 points.
Speed limits
While prices can at various times steam far ahead of intrinsic values, market prices ultimately do have a speed limit.
The natural speed limit for real estate prices is ultimately our ability to service mortgage repayments. Periodically dwelling price-to-income ratios may become very high indeed (Hong Kong being a prime contemporary example) but with property prices sensitive to interest rates, there may come a critical point where property ceases to be affordable.
In this context, the easing of property values and the slicing of the cash interest rate to 3.50% in Australia has delivered a welcome affordability dividend through 2011 and 2012 to date.
Of course, it is very difficult to calculate an intrinsic value for residential property, because values (perhaps one should say prices) tend to be based as much around what property is worth to emotion-driven homeowners as much as they are by imputed rents or yields for investors.

What we can observe from price history charts and from falling interest rates is that affordability is better than it has been, and in some cities (e.g. Sydney) affordability of certain properties has increased dramatically since early 2004.
The natural speed limit for stock prices is governed by the ability of companies to generate cash.
The technology stock bubble showed that prices can become hugely irrational for a period of time, but ultimately a company must start to generate cash to justify its valuation (the rational valuation of a company is the sum of its future cash-generating ability adjusted for risk and discounted back to today's value).

The companies that never generated any cash or profits during and after the tech stock boom eventually became valued at somehwere close to $nil. No cash-generating ability ultimately equals no value.
Conclusion: three lessons
There are three things that we should learn from this.
1 - Firstly, it can be hugely beneficial to attempt to time the market.
In property, this means we should look to invest in cities which are due to experience a boom in population and growing household incomes which will allow values to increase in the future by increasing the speed limit for prices. We should also look to cities which have not recently experienced booming values.
In stocks, this means we should look to buy when price-earnings ratios are below their long-term average.
2 - Secondly, as share prices do not always revert to the mean (i.e. companies can go bust, Enron-style) we should not risk all of our investment capital in a handful of company stocks – some diversification is preferable, whether it is through investing in a more diversified portfolio of stocks or into other asset classes such as property or fixed interest investments such as bonds.
3 - Thirdly, history shows us that is actually impossible to consistently time the market perfectly, but if we allow ourselves time in the market, growth asset classes tend to be forgiving of imperfect timing.
***
What a wonderful Olympics it has been, it will be very sad when there is nothing for us to watch over the next week!
Still recovering from City2Surf, but don’t feel too stiff today. Sydney Marathon is in five weeks – I did the Marathon here a few years ago and vowed never to do it again…now I’m thinking, should I...could I…?